CRR Article 134.7 refers to ‘bargain option’ under a leasing contract, without specifying the interactions between this concept and ‘leasing residual values’. We understand from this article that CRR encompasses two mutually exclusive exposure class assignment rules for leasing residual values.

A leasing residual value under Title II, chapter 2 of CRR may either:

1. be covered by a bargain option the exercise of which is reasonably certain and treated as a minimum lease payment. It entails to assign the residual value to the corresponding exposure class according to CRR article 112.

Or, 

1. remain in the other items class of exposures. 

In addition, article 134.7 of CRR introduces a binding treatment for leasing residual value exposures. The risk-weight amount shall be computed through the formula: “1/t * 100 % * residual value, where t is the greater of 1 and the nearest number of whole years of the lease remaining.”

It is unclear if the dedicated ‘1/t’ treatment to assign a risk-weighted amount to a leasing residual value is excluded through the new class of exposure assignment and the application of CRR article 113.1 which states: ‘The application of risk weights shall be based on the exposure class to which the exposure is assigned’.

From a regulatory standpoint, CRR comprises examples where exposures are assigned to an exposure class and assigned a risk-weight according to the requirements of another exposure class under the standardized approach. 

For example: exposures to regional governments or local authorities may be treated as exposures to central governments under article 115.1 of CRR without being assigned to the latter exposure class.

Besides and from the risk perspective, should the ‘1/t’ treatment be restricted to the ‘other items’ exposure class, one may consider the inconsistencies it may yield.

The requirements for the exposure class assignment of leasing residual values are grounded on the existence of a bargain option (‘BO’) the exercise of which is reasonably certain.

Such bargain option: 

• has an ‘attractive’ strike price for the lessee, sufficiently below the estimated market value of the leased asset at contract end. ​

• this attractiveness of the RV is supported by a higher level of capital amortization through contractual minimum lease payments or subsidies. ​

• reduces the risk that the leased asset returns on the balance sheet of the lessor at contract end. From the lessor’s perspective, the existence of reasonably certain bargain option reduces the remarketing effort and a potential loss in the value of the leased asset at the same time. 

Should the 1/t treatment be restricted to residual values assigned to the ‘other items’ exposure class under the standardized approach for credit risk, the latter could yield lower risk-weights than residual values covered by a bargain option the exercise of which is reasonably certain.

Residual Value exposure RWA computation examples under the assumption that assignment to the exposure class determines the risk-weights: 

• Residual Value amount = 10
• Contract length = 3years 

Case 1: no bargain option, 1/t rule

Case 2: Obligor is a retail individual (RW=75%), there is reasonably certain bargain option

Case 3: Obligor is an unrated corporate (RW=100%), there is reasonably certain bargain option

Our understanding of the assignment of the bargain option whose exercise is reasonably certain to the exposure class of the lessee is that the regulation consider that, despite its optionality, this option constitute a form of credit protection on the residual value (as for a third party that could be required to purchase the residual value) and therefore this exposure is considered as secured by the lessee. However even if this option is not qualifying as credit risk mitigation technique under CRR Chapter 4), one may question the risk-weight obtained hereabove by analogy to the first letter order of CRR expressed under article 193.1: “No exposure in respect of which an institution obtains credit risk mitigation shall produce a higher risk-weighted exposure amount or expected loss amount than an otherwise identical exposure in respect of which an institution has no credit risk mitigation.”

Finally, one should consider that actual risk attached to the residual value of a leased asset consists in a material decrease of its mark-to-market value against its book value. 

In such circumstances, a lessor would be provisioning this decrease in the value of its asset against own funds. The existence of a bargain option would not yield any difference in that regard.